Although exchange-traded funds track everything from the S&P 500 to an ultra-specific index made up of companies that support NASCAR's Sprint Cup Series, they all generally work the same. They mirror the holdings of an index, keep costs and turnover low, and aim to at least match the benchmark.
But even that age-old indexing formula is changing at some ETF firms, which are altering the recipe by which stocks are weighted in an index. Instead of following the conventional method of weighting companies based on market capitalization, so-called fundamental ETFs weight companies based on financial metrics such as revenue, dividends, and cash flow. The idea is to break the link between a stock's price and its weight on an index, which can help insulate investors from wild swings in the market. U.S. News talked with some experts about how these ETFs work and what role they could play your portfolio.
How fundamental ETFs work. Firms that offer fundamental ETFs weight funds based on a specific metric or combination of metrics, such as revenue, dividends, earnings, sales, or cash flow. They re-evaluate the rankings and weighting of fund holdings on an annual basis and rebalance the fund as needed to account for any changes in the market. For example, fundamental ETF purveyor RevenueShares weights funds based on revenue. "We take the S&P 500 or 400 or 600 and once per year, we calculate each constituent's stock's revenue," says Sean O'Hara, president of RevenueShares. "Then we give [a company] its representative weight based on its revenue." O'Hara favors this method because revenue is something all companies report and, over time, he says funds weighted by revenue tend to be less volatile than their market cap-weighted counterparts.
Another fund firm, WisdomTree, bases some of its fundamental ETFs on dividends. "Dividends are the most intuitive measure of value," says Jeremy Schwartz, WisdomTree's Director of Research. "From basic finance 101, you learn that assets are tied to their cash flows and for stocks, cash flows are dividends. So theoretically, dividends are a very important factor."
Investment firm Research Affiliates created another approach to fundamental indexing, which involves using multiple measures of a company to determine weighting structures. The company developed a series of indexes in conjunction with The Financial Times and the London Stock Exchange (FTSE), which incorporates sales, cash flow, dividends, and book value. "The idea was to have a combination of these four fundamental factors that would smooth out any of the individual issues [associated with] using just one fundamental factor," says Ed McRedmond, senior vice president of institutional and portfolio strategies at Invesco PowerShares. Invesco's PowerShares group partnered with Research Affiliates in 2003 to offer a line of ETFs linked to FTSE RAFI indexes.
[See ETFs for Beginning Investors.]
Why it matters. Fundamental ETFs essentially break the link between stock price and portfolio weight, which helps equalize major swings in the market. "We're trying to judge price movements relative to some measure of value," says Schwartz. "It's a way to protect yourself from bubbles."
Most experts and even proponents of fundamental ETFs don't deny that over the long term, the market is fairly efficient in pricing things correctly. However, over the short term, market cap-weighted funds can be more susceptible to bubbles and crashes because they give the highest-priced stocks the largest weighting and the lowest-priced stocks the smallest weighting. As a result, market cap-weighted funds tend to overweight overvalued stocks and underweight undervalued stocks.
"When stocks double in price, for instance, a market cap-weighted index will just hold twice as much weight of that stock," Schwartz says. "They never say, 'Should I hold twice as much of this stock?' They're simply following the market trend."
However, by rebalancing fundamental ETFs on a yearly basis, investors can actually convert the market's short-term inefficiencies into a benefit. "Over a 10-year period, the market probably does have an efficient pricing mechanism built into it," O'Hara says. "But for a week or so it might not be [priced correctly], even for a year or longer it might not be. So by rebalancing, we take advantage of that short-term inefficiency."
How fundamental ETFs stack up. Not surprisingly, fundamental ETFs tend to do well when the market favors the metric on which their weightings are based. "Every factor will have its day," says James Early, advisor of the Motley Fool Income Investor newsletter and a former hedge fund analyst. "We could be in a dividend market, in which case you would want a dividend-weighted ETF. We could be in an earnings market where the market is just favoring fast earnings growth in which case an earnings-weighted ETF would be good."
But it really comes down to diversification, Early says, and that means having some market-cap weighted ETFs in your portfolio as well. "In a momentum market, cap-weighting is going to win," he says. "If we are in a kind of raging bull market, you want to be in a cap-weighted ETF because the faster growing stuff is just going to naturally assume a larger portion of your portfolio."
That's all well and good if the "faster growing stuff" continues to grow, but once it slows down, you'll be glad you have fundamental ETFs on your side. "You might then want an equal-weighted or dividend-weighted ETF because that's going to protect you," Early says. "You won't be so heavily weighted into the rising stars that may end up falling."
The drawbacks. Along with the advantages of fundamental ETFs, there are some drawbacks of which investors should be aware. Fundamental ETFs tend to be more expensive to own than regular ETFs, but, as with most ETFS, they still cost much less than the average mutual fund. "You've really got to get the expense ratio low and that could be an issue with some of these ETFs," Early says. "I like expense ratios under 0.4 percent."
Fundamental ETFs that Early recommends include WisdomTree's Large-Cap Dividend fund (symbol DLN) with an expense ratio of 0.28 percent and Rydex's equally-weighted S&P ETF (RSP), which butts up against his max expense ratio of 0.4 percent.
Investors can expect to see these types of ETFs underperform in markets where overheated sentiment gets ahead of fundamentals. "In a bubble we would lag, but when the bubble bursts we'll get back all that underperformance and then some," O'Hara says. "In a huge market sell-off, again, we might lag, but when we rebalance we'll pick all that back up. It's kind of cyclical because people's emotions are cyclical."
While many fundamental ETFs have posted impressive numbers since their inception five or six years ago, cautious investors and financial analysts still have questions about the long-term sustainability and performance of these products, especially given their structural divergence from that central tenet of index investing - that markets really are efficient. "It's a challenge to what is deemed to be conventional wisdom rooted in a history that perhaps is not valid anymore," O'Hara says. This newer type of fund remains a small piece of the overall ETF market, but the category's solid performance and cost efficiency are starting to make fundamental ETFs more and more attractive to investors.